Finding the Right Financing Mix: The Capital Structure Decision

1. Finding the Right Financing Mix: The Capital Structure Decision Aswath Damodaran Stern School of Business

2. First Principles • Invest in projects that yield a return greater than the minimum acceptable hurdle rate. • The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects. • Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. • If there are not enough investments that earn the hurdle rate, return the cash to stockholders. • The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.

3. The Agenda • What determines the optimal mix of debt and equity for a company? • How does altering the mix of debt and equity affect investment analysis and value at a company? • What is the right kind of debt for a company?

4. Costs and Benefits of Debt • Benefits of Debt • Tax Benefits • Adds discipline to management • Costs of Debt • Bankruptcy Costs • Agency Costs • Loss of Future Flexibility

5. Tax Benefits of Debt • (a) Tax Benefits: Interest on debt is tax deductible whereas cashflows on equity (like dividends) are not. • Tax benefit each year = t r B • After tax interest rate of debt = (1-t) r • Proposition 1: Other things being equal, the higher the marginal tax rate of a corporation, the more debt it will have in its capital structure.

6. Issue 1: The Effects of Taxes 1. You are comparing the debt ratios of real estate corporations, which pay the corporate tax rate, and real estate investment trusts, which are not taxed, but are required to pay 95% of their earnings as dividends to their stockholders. Which of these two groups would you expect to have the higher debt ratios?  The real estate corporations  The real estate investment trusts  Cannot tell, without more information

7. Debt adds discipline to management • Equity is a cushion; Debt is a sword; • The management of firms which have high cashflows left over each year are more likely to be complacent and inefficient.

8. Issue 2: Debt and Discipline 2. Assume that you buy into this argument that debt adds discipline to management. Which of the following types of companies will most benefit from debt adding this discipline?  Conservatively financed, privately owned businesses  Conservatively financed, publicly traded companies, with a wide and diverse stock holding  Conservatively financed, publicly traded companies, with an activist and primarily institutional holding.

9. Bankruptcy Cost • The expected bankruptcy cost is a function of two variables-- • the cost of going bankrupt • direct costs: Legal and other Deadweight Costs • indirect costs: Lost Sales... • durable versus non-durable goods (cars) • quality/safety is important (airlines) • supplementary services (copiers) • the probability of bankruptcy

10. The Bankruptcy Cost Proposition • Proposition 2: Other things being equal, the greater the implicit bankruptcy cost and/or probability of bankruptcy in the operating cashflows of the firm, the less debt the firm can afford to use.

11. Issue 3 : Debt & Bankruptcy Cost 3. Rank the following companies on the magnitude of bankruptcy costs from most to least, taking into account both explicit and implicit costs:  A Grocery Store  An Airplane Manufacturer  High Technology company

12. Agency Cost • Stockholders incentives are different from bondholder incentives • Taking of Risky Projects • Paying large dividends • Proposition 3: Other things being equal, the greater the agency problems associated with lending to a firm, the less debt the firm can afford to use.

13. Loss of future financing flexibility • When a firm borrows up to its capacity, it loses the flexibility of financing future projects with debt. • Proposition 4: Other things remaining equal, the more uncertain a firm is about its future financing requirements and projects, the less debt the firm will use for financing current projects.

14. Relative Importance Of Financing Planning Principles

15. Debt: A Balance Sheet Format Advantages of Borrowing Disadvantages of Borrowing 1. Tax Benefit: 1. Bankruptcy Cost: Higher tax rates --> Higher tax benefit Higher business risk --> Higher Cost 2. Added Discipline: 2. Agency Cost: Greater the separation between managers Greater the separation between stock- and stockholders --> Greater the benefit holders & lenders --> Higher Cost 3. Loss of Future Financing Flexibility: Greater the uncertainty about future financing needs --> Higher Cost

16. A Hypothetical Scenario • Assume you operate in an environment, where • (a) there are no taxes • (b) there is no separation between stockholders and managers. • (c) there is no default risk • (d) there is no separation between stockholders and bondholders • (e) firms know their future financing needs

17. The Miller-Modigliani Theorem • In an environment, where there are no taxes, default risk or agency costs, capital structure is irrelevant. • The value of a firm is independent of its debt ratio.

18. Implications of MM Theorem (a) Leverage is irrelevant. A firm's value will be determined by its project cash flows. (b) The cost of capital of the firm will not change with leverage. As a firm increases its leverage, the cost of equity will increase just enough to offset any gains to the leverage

19. What do firms look at in financing? • A. Is there a financing hierarchy? • Argument: • There are some who argue that firms follow a financing hierarchy, with retained earnings being the most preferred choice for financing, followed by debt and that new equity is the least preferred choice.

20. Rationale for Financing Hierarchy • Managers value flexibility. External financing reduces flexibility more than internal financing. • Managers value control. Issuing new equity weakens control and new debt creates bond covenants.

21. Preference rankings long-term finance: Results of a survey Ranking Source Score 1 Retained Earnings 5.61 2 Straight Debt 4.88 3 Convertible Debt 3.02 4 External Common Equity 2.42 5 Straight Preferred Stock 2.22 6 Convertible Preferred 1.72

22. Issue 5: Financing Choices 5. You are reading the Wall Street Journal and notice a tombstone ad for a company, offering to sell convertible preferred stock. What would you hypothesize about the health of the company issuing these securities?  Nothing  Healthier than the average firm  In much more financial trouble than the average firm

23. What is debt... • General Rule: Debt generally has the following characteristics: • Commitment to make fixed payments in the future • The fixed payments are tax deductible • Failure to make the payments can lead to either default or loss of control of the firm to the party to whom payments are due.

24. What would you include in debt? • Any interest-bearing liability, whether short term or long term. • Any lease obligation, whether operating or capital.

25. Converting Operating Leases to Debt • The “debt value” of operating leases is the present value of the lease payments, at a rate that reflects their risk. • In general, this rate will be close to or equal to the rate at which the company can borrow.

26. Operating Leases at The Gap • Operating lease expenses in 1995 = $304.6 million • Cost of Debt in 1995 = 7.30% • Duration of Lease Obligations = 12 yrs • PV of Lease Expenses = $304.6 million for 12 years at 7.30% = $2,381 million

27. Measuring Financial Leverage • Two variants of debt ratio • Debt to Capital Ratio = Debt / (Debt + Equity) • Debt to Equity Ratio = Debt / Equity • Ratios can be based only on long term debt or total debt. • Ratios can be based upon book value or market value.

28. Measuring Cost of Capital • It will depend upon: • (a) the components of financing: Debt, Equity or Preferred stock • (b) the cost of each component • In summary, the cost of capital is the cost of each component weighted by its relative market value. WACC = ke (E/(D+E)) + kd (D/(D+E))

29. The Cost of Debt • The cost of debt is the market interest rate that the firm has to pay on its borrowing. It will depend upon three components- • (a) The general level of interest rates • (b) The default premium • (c) The firm's tax rate

30. What the cost of debt is and is not.. • The cost of debt is • the rate at which the company can borrow at today • corrected for the tax benefit it gets for interest payments. Cost of debt = kd = Long Term Borrowing Rate(1 - Tax rate) • The cost of debt is not • the interest rate at which the company obtained the debt it has on its books.

31. What the cost of equity is and is not.. • The cost of equity is • 1. the required rate of return given the risk • 2. inclusive of both dividend yield and price appreciation • The cost of equity is not • 1. the dividend yield • 2. the earnings/price ratio

32. Costs of Debt & Equity A recent article in an Asian business magazine argued that equity was cheaper than debt, because dividend yields are much lower than interest rates on debt. Do you agree with this statement  Yes  No Can equity ever be cheaper than debt?  Yes  No

33. Calculate the weights of each component • Use target/average debt weights rather than project-specific weights. • Use market value weights for debt and equity.

34. Target versus Project-specific weights • If firm uses project-specific weights, projects financed with debt will have lower costs of capital than projects financed with equity. • Is that fair? • What do you think will happen to the firm’s debt ratio over time, with this approach?

35. Market Value Weights • Always use the market weights of equity, preferred stock and debt for constructing the weights. • Book values are often misleading and outdated.

36. Fallacies about Book Value 1. People will not lend on the basis of market value. 2. Book Value is more reliable than Market Value because it does not change as much. 3. Using book value is more conservative than using market value.

37. Issue: Use of Book Value Many CFOs argue that using book value is more conservative than using market value, because the market value of equity is usually much higher than book value. Is this statement true, from a cost of capital perspective? (Will you get a more conservative estimate of cost of capital using book value rather than market value?)  Yes  No

38. Why does the cost of capital matter? • Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital.

39. Optimum Capital Structure and Cost of Capital • If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized.

40. Applying Approach: The Textbook Example

41. WACC and Debt Ratios Weighted Average Cost of Capital and Debt Ratios 11.40% 11.20% 11.00% 10.80% 10.60% WACC 10.40% 10.20% 10.00% 9.80% 9.60% 9.40% 0 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Debt Ratio

42. Current Cost of Capital: Disney • Equity • Cost of Equity = 13.85% • Market Value of Equity = $50.88 Billion • Equity/(Debt+Equity ) = 82% • Debt • After-tax Cost of debt = 7.50% (1-.36) = 4.80% • Market Value of Debt = $ 11.18 Billion • Debt/(Debt +Equity) = 18% • Cost of Capital = 13.85%(.82)+4.80%(.18) = 12.22%

43. Mechanics of Cost of Capital Estimation 1. Estimate the Cost of Equity at different levels of debt: Equity will become riskier -> Beta will increase -> Cost of Equity will increase. Estimation will use levered beta calculation 2. Estimate the Cost of Debt at different levels of debt: Default risk will go up and bond ratings will go down as debt goes up -> Cost of Debt will increase. To estimating bond ratings, we will use the interest coverage ratio (EBIT/Interest expense) 3. Estimate the Cost of Capital at different levels of debt 4. Calculate the effect on Firm Value and Stock Price.

44. Medians of Key Ratios : 1993-1995

45. Process of Ratings and Rate Estimation • We use the median interest coverage ratios for large manufacturing firms to develop “interest coverage ratio” ranges for each rating class. • We then estimate a spread over the long term bond rate for each ratings class, based upon yields at which these bonds trade in the market place.

46. Interest Coverage Ratios and Bond Ratings If Interest Coverage Ratio is Estimated Bond Rating > 8.50 AAA 6.50 - 8.50 AA 5.50 - 6.50 A+ 4.25 - 5.50 A 3.00 - 4.25 A– 2.50 - 3.00 BBB 2.00 - 2.50 BB 1.75 - 2.00 B+ 1.50 - 1.75 B 1.25 - 1.50 B – 0.80 - 1.25 CCC 0.65 - 0.80 CC 0.20 - 0.65 C < 0.20 D

47. Spreads over long bond rate for ratings classes

48. Current Income Statement for Disney: 1996 Revenues 18,739 -Operating Expenses 12,046 EBITDA 6,693 -Depreciation 1,134 EBIT 5,559 -Interest Expense 479 Income before taxes 5,080 -Taxes 847 Income after taxes 4,233 • Interest coverage ratio= 5,559/479 = 11.61 (Amortization from Capital Cities acquistion not considered)

49. Estimating Cost of Equity Current Beta = 1.25 Unlevered Beta = 1.09 Market premium = 5.5% T.Bond Rate = 7.00% t=36% Debt Ratio D/E Ratio Beta Cost of Equity 0% 0% 1.09 13.00% 10% 11% 1.17 13.43% 20% 25% 1.27 13.96% 30% 43% 1.39 14.65% 40% 67% 1.56 15.56% 50% 100% 1.79 16.85% 60% 150% 2.14 18.77% 70% 233% 2.72 21.97% 80% 400% 3.99 28.95% 90% 900% 8.21 52.14%

50. Disney: Beta, Cost of Equity and D/E Ratio